Israel
Challenges Mounting – Downgrading Growth Forecasts
January 21, 2009

By Tevfik Aksoy | Istanbul

Israel Unlikely to Decouple from Main Trading Partners

The impact of the ongoing global slowdown and challenges in financial markets had been taking their toll on Israel’s growth. Various macro indicators point to a noticeable slowdown in growth in 4Q08, which is likely to linger for at least a couple more quarters in 2009. Following an average 5% growth rate in the past 20 quarters, we expect that the real growth rate had declined to 0%Y in 4Q08. This would bring the overall growth rate to 3.7%Y, which would constitute the slowest pace since 2003. 

On the back of the recent growth forecast downgrades by our US and European economics teams, as well as the weakness in incoming data on economic activity in Israel and uncertainties surrounding the timing of fiscal policy-making, we are lowering our real GDP growth rate forecast for 2009 to 0%Y. We are also downgrading our 2010 growth rate to 3.4%Y from 4.9%Y previously.

A Lifeline from the Finance Ministry?

Recently, the Finance Ministry declared that a program to guarantee NIS6 billion (US$1.6 billion) in borrowing by the commercial banks would be introduced, which is expected to improve the capital base and help increase overall private lending. Essentially, these state guarantees might enable banks to raise capital and even provide a bigger base for lending according to the Finance Ministry. It is too early to predict if the plan will succeed, but if the program helps to ease the burden of the credit crunch even marginally, it might raise the upside risks to our growth forecasts, especially looking into 2010. 

Export Growth to Remain Under Pressure

Exports constitute some 45% of Israel’s GDP and remain one of the key drivers of growth. After a robust rise in exports over the past few years, the ongoing decline in external demand finally started to show itself as the yearly growth rate of Israeli exports turned sharply negative. Since around 35% of exports are geared towards the US and some 30% to the EU, the anticipated weakness in growth in these countries suggests that at least the external component of growth is likely to be muted in 2009. In line with the anticipated pick-up in growth activity in the US and the euro area in 2010, we are also envisaging a recovery in Israel (albeit a relatively modest one).

Contributing significantly to overall growth between 2003 and 2008, exports are expected to provide only a marginal help in 2009 and then improve noticeably in 2010 as long as the external backdrop permits. A similar change is expected in imports, especially surrounding the weakness in commodity prices (mainly energy). Hence, the contribution of net exports might be close to zero in 2009 but turn positive once again next year.

State-of-the-Economy Composite: Weakening Fast

In December, the composite state-of-the-economy index published by the Bank of Israel dropped by 1%, on top of the weakening witnessed since last July. The overall decline in the index reached some 3% since the peak of last summer, and this had been a clear sign of the ongoing easing in the growth rate, in our view. The main weakness behind the composite index had stemmed from a broad-based decline in industrial production and exports as well as the softening in trade and services revenues.

Inflation Is Likely to Benefit from the Slowdown

Inflation had been fairly volatile in Israel over recent years. On the back of rising food and housing prices coupled with buoyant domestic demand, the BoI had been facing serious challenges in attempting to bring inflation inside the price stability band of 1-3%. Despite the sharp drop in economic activity, commodity and food prices in 2H08, the BoI failed to achieve the price stability target perhaps because of the deliberate choice of pre-empting the anticipated weakness in the economy. Essentially the BoI cut the main policy rate by a total of 250bp in 2008, most of which took place in the last quarter. Hence, headline inflation rose to 3.8%Y in 2008 from 3.4%Y in 2007 after seeing a peak of 5.5%Y in September.

In line with our growth rate downgrade as well as the ongoing weakness in commodity prices, we are lowering our CPI inflation forecasts for 2009 and 2010. We now expect inflation to enter the price stability band of 1-3% by mid-2009 and we predict that it will stay inside it during the rest of the year as well as in 2010. Our year-end forecasts for inflation now stand at 1.1% in 2009 and 1.4% in 2010.

Policy Rates: Further Room to Cut

In our view, inflation will not be an issue in the near future, especially in the absence of an external shock (such as a commodity price reversal). The policy rate that stands at 1.75% had been the lowest on record and, given the absence of demand pressures, we believe that there is further room to ease. Especially considering that the US fed policy rate is expected to remain near zero during 2009, the interest rate differential also justifies cuts by the BoI, in our view. We expect the central bank to ease rates further by 50bp at the next policy meeting, possibly followed by another 50bp in the coming months.

In case the general elections scheduled for February 10 see a rapid formation of a government and the budget for 2009 is passed with a relevant fiscal stimulus package attached, the BoI might choose to remain on the sidelines, in our view. However, the deteriorating growth prospects are likely to take their toll on tax revenues, leading to a budget deficit possibly exceeding 4% of GDP in 2009. Recall that the current official working assumption of growth for 2009 still stands at 3.5%, which envisages a budget deficit of 1% of GDP. Clearly, the current circumstances necessitate an overall revision of these assumptions and targets, in our view, but this might not materialize until after a government is put in place in late 1Q. In Israel, the budget deficit had been declining steadily since 2004 and nearly reached a balance in 2007. In 2008, however, the fiscal performance had been showing signs of weakening, especially in 4Q, such that the headline deficit reached some NIS15.2 billion (around 2.1% of GDP). In our view, the fiscal prospects in 2009 remain challenging, which might also place a cap on the extent of monetary easing that the BoI might adopt.

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Mexico
Consumers – Nowhere to Hide
January 21, 2009

By Luis Arcentales | New York

Conditions for Mexico’s struggling consumers are turning from bad to worse.  On January 16, when Banco de Mexico began its easing cycle with a 50bp rate cut, the policy statement contained a grim assessment of the economy by highlighting that the US growth slump was “affecting (Mexican growth) very negatively”.  Importantly, the communiqué stressed that recent data suggested that weakness was not limited to exports, but it also included “private consumption, employment and wage mass”. 

With Mexican consumers getting hit hard on all fronts, Banxico’s downbeat assessment of the domestic side of the economy seemed fair, in our view. First, the economy began shedding jobs at a rapid pace in the last few months of 2008.  Second, last year’s upturn in inflation – coupled with muted wage growth – has translated into falling real wages.  Third, consumer credit growth has come to a halt as the combination of rising credit card delinquency rates and economic uncertainty has made banks cautious.  Fourth, after a short-lived spike in October, remittances have resumed their downward trend.  Lastly, Mexico’s violent crime problem has likely hurt already-depressed consumer confidence levels. 

Indeed, the latest activity and sales data already reflect consumers’ mounting pain. In October, the services sector – which represents over 60% of the economy and is more closely linked to the consumer – posted a 0.2% annual drop.  While the decline was modest, it represents a remarkable deterioration from its 2.8% pace in 3Q and 3.6% in 1H08.  Within Mexico’s industrial sector – which has contracted for seven consecutive months into November – the sudden slowdown on the services front is particularly worrisome.  In addition, the holiday season wasn’t a particularly happy one for Mexico’s retailers as December sales plunged -4.5% from a year earlier, as reported by retail chamber ANTAD.  Some payback from November’s 9.9% jump and the calendar exaggerated the slump; however, December’s sales performance was discouraging in light of the heavy promotional activity by retailers ranging from rebates as high as 20%, zero interest rate offers and steep discounts on hard-hit discretionary areas like clothing and toys. And credit-sensitive items like car sales, which are not included in ANTAD’s index, plunged 18.1% in 4Q. 

Consumers: Nowhere to Hide

Nowhere is the deterioration in Mexico’s consumer backdrop more evident than in labor markets.  The rate of unemployment spiked to 4.47% in November, the highest level in the survey’s near nine-year history.  Importantly, the increase in the unemployment rate was accompanied by a meaningful drop in labor participation, suggesting true underlying deterioration in Mexico’s job market.  And this worrisome picture is consistent with data from the narrower formal jobs survey from Mexico’s Social Security Institute.   

The economy has been shedding formal employment positions at a remarkable pace, both in terms of magnitude and speed since September.  While formal employment was 0.1% in 4Q compared with the same period in 2007, annual comparisons mask an important contraction once adjusted for seasonal swings.  From its seasonally adjusted peak in August, the economy has lost over 175,000 jobs or 1.2% of the total – around twice the absolute number (-83,000) and percentage of total (-0.7%) suffered in the four months after employment peaked in October 2000 during the last recession.   If the pace of the past four months was sustained over the course of 2009 – which is not our base case scenario – the economy would eliminate over half a million jobs, a figure that stands in sharp contrast to the consensus estimates for gains of 81,000 positions this year.  Meanwhile, the pace of job losses accelerated sharply in 4Q08 as jobs contracted at a sequential annualized clip in excess of 3% – a rate comparable to the worst pace during the 2001 recession, according to our calculations.    

Not surprisingly, the manufacturing sector – where the link to the US is the strongest – accounted for the bulk of the job losses over the past four months with nearly 150,000 positions.  Given the government’s focus on infrastructure spending and housing, what may come as a surprise is that construction was responsible for the rest of the job losses, with over 50,000 positions eliminated over the same period.  Indeed, in 4Q both manufacturing and construction jobs contracted at a dramatic pace in excess of 10% annualized.  The rest of the economy – which accounts for 65% of total employment – added a modest 26,000 jobs in this period, not nearly enough to offset the significant drag from manufacturing and construction. 

Though real wage gains have not been a major driver of consumption in recent years, wages have turned into an additional headwind.  Average contractual nominal wages rose 4.41% in 2008, just 0.18pp higher than in 2007, while inflation averaged 5.12% over the same period – 1.16pp higher than in 2007.  Alternative indices from the central bank that use trailing inflation and 12-month forward inflation expectations to estimate real wages posted annual declines of 1.8% and 0.1% in 4Q08, respectively (see “Mexico: What Wage Pressure?” EM Economist, August 1, 2008).

Credit growth, which for years represented a tailwind for consumers, has come to a halt.  The most recent data from the central bank for 3Q show that credit to the consumer – from commercial banks and non-bank lending institutions – expanded by a modest 1.6%Y in real terms, following seven consecutive years of double-digit growth.  In addition to the negative impact from general economic uncertainty, lending institutions are limiting credit to the consumer due to rising credit card delinquency rates. The non-performing loan ratio of bank credit cards reached 10% in November, up from around 7% the year before (we estimate that credit cards represent around 60% of bank consumer lending).  And for those consumers with access to loans, the costs have risen sharply: credit card rates averaged 41.78% in November, an increase of over 10pp over the past year. 

While modest in comparison to the sharp turns in employment and credit, remittances have maintained their downward trend. Following a surprising 13% annual jump last October – likely driven by the weakening in the peso, which encouraged workers to send more money home – remittances plunged 10.7% in November. To be fair, the decline in remittances in the January-November period has been modest (-2.6%), but the drivers behind this drop – namely mounting job losses in the US, better border patrol and more strict controls on US employers – are likely to remain in place, adding pressure on remittances. 

Though harder to quantify, Mexico’s growing crime problem is likely an additional factor weighing heavily on consumer sentiment, which is at record-low levels.  It is also likely to have an impact on investment decisions, although it is difficult to distinguish the damage caused by growing violent crime from the damage caused by the drop in export demand.

Banco de Mexico’s Response

Following Banco de Mexico’s decision to cut rates by 50bp on January 16, we are revising our interest rate forecast for 2009.  We now expect Banco de Mexico to ease rates by a total of 300bp in 2009, bringing rates down to 5.25% by end-2009 from 8.25% at the start of the year.  We had previously expected 175bp of cuts to 6.50%, which assumed that the easing cycle would start at a more modest 25bp pace (see “Latin America: Easing Cycle Begins”, EM Economist, January 16, 2009). 

Banco de Mexico balanced its January 16 decision with some hawkish comments, even as it stressed that the downside growth risks had deteriorated more than the risk to inflation. Specifically, the statement emphasized that the central bank’s board will need to see inflation moving in line with its quarterly inflation path – set to be updated on January 28 – in order to continue to reduce interest rates.  Recall that the central bank’s concern that it would likely miss its 4Q08 inflation path of 5.5-6.0% played a role in the decision not to ease rates at the last meeting of 2008.  Accordingly, these lingering inflation concerns are likely to prevent Banco de Mexico from accelerating the pace of easing from the 50bp cuts we now expect in the coming months. 

Bottom Line

Conditions for Mexico’s struggling consumers are turning from bad to worse, due primarily to a combination of mounting job losses, falling real wages and limited credit availability.  For a sluggish Mexican economy whose struggling industrial sector is already in recession, the incipient retrenchment on the consumer front – which is evident in indicators ranging from retail and automobile sales to broader service sector data – suggests that the economy is likely to experience an important contraction over the course of 2009.  While Banco de Mexico may indeed respond more aggressively than most observers thought just a few months ago, we doubt that the actions will prevent the Mexican economy from posting a larger-than-expected slump in activity this year.

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Hong Kong
Factoring in More Downside to Growth
January 21, 2009

By Denise Yam, CFA | Hong Kong

Reassessing Hong Kong’s Macro Outlook Amid Sharp Deterioration in Global Economic Conditions

Global economic conditions have turned decisively more negative since our last forecasts for the Hong Kong economy and our call for negative growth and the return of deflation in 2009.  As a result, we are reassessing the economic outlook and downgrading our projections again.

Global financial markets have witnessed an unprecedented plunge in sentiment as economies grapple with the ramifications of the financial tsunami that originated from the US subprime crisis.  What keeps surprising (and disappointing) investors is the extent of the contagion effects from the financial industry to almost all economic sectors.  As more decades- and even centuries-old corporates and multinationals run into financial difficulties or even file for bankruptcy, our global economics team has unveiled hefty cuts to growth outlooks for the industrial world.  The US economy is now forecast to contract by 2.4% in real terms this year, Euroland by 1.6% and Japan by 2%.  Such a synchronized global recession is undoubtedly unseen since World War II.  While Hong Kong (and indeed the rest of the world) has been looking to the Mainland as a source of growth resilience, it appears that China, while continuing to outperform and gain share in the global economy and global trade, is also facing immense economic difficulties ahead.  Negative export (and overall trade) growth unseen since 1976 is expected to slash China’s real GDP growth to just 5.5% in our newly revised forecasts, the weakest since the Cultural Revolution (1967-68) (see China Economics: 2009 Outlook Downgrade: Getting Much Worse Before Getting Better, January 18, 2009). 

Harsh Blow to Hong Kong’s External-Oriented Sectors…

The key driver of our latest revisions to Hong Kong’s macro outlook is the cuts to forecasts for both merchandise and invisible trade.  Sharp drops in trade flows have already been observed in the region in recent months.  Extreme weakness in developed markets demand is expected to slash shipments through Hong Kong (as entrepôt between China and the rest of the world), for which we now expect contraction in excess of 10%Y, more severe than that experienced in 1998 (Asian Financial Crisis) and 2001 (collapse of the tech hype).  Exports of services, which makes up more than 40% of Hong Kong’s GDP and which has been a key growth driver for the economy, is expected to contract for the first time since 1998, by 8%.  Trade-related services (half of the total) will likely see a contraction in line with merchandise trade, while non-trade-related services will also likely see a lull as inbound tourism slumps, multinationals cut down on consulting and marketing expenses, and financial market conditions remain unfavorable for fundraising activities by mainland enterprises.

…and the Pain Seeps through the Domestic Economy

Given the external-oriented nature of the Hong Kong economy, the more negative outlook on trade certainly puts further pressure on domestic demand, in addition to the pain from the negative wealth effect from asset depreciation.

Although aggressive financial relief measures have brought about much lower interest rates of late, the availability of credit to the non-financial sectors has yet to normalize and become supportive of real economic activity.  It remains a distinct risk that many SMEs, customarily dependent on bank credit for working capital, will face cash flow difficulties in the coming months.  A wave of company closures could be expected in the next few months, as consumer and business spending cools further after the Lunar New Year season, with layoffs adding to the jobless count.  Even for the majority of the businesses that will manage to weather the downcycle, reduced profits or losses are set to hurt consumption and investment sentiment on the part of entrepreneurs.

Cutting Growth Projections

Steeper declines in trade flows (merchandise exports -9.9%, imports -11.5%, service exports -8%) are expected to bring about weaker consumption and investment than we had previously forecast.  Beyond the negative wealth effect, private consumption is seeing another leg down from worsening labor market conditions (job losses and salary/bonus cuts).  We now see private consumption shrinking 2.5% in real terms this year versus 0.5% growth previously.  Investment is not only being hampered by the reduced availability of credit, but also by the glum outlook for global demand.  Private sector capex is expected to fall 5% (versus -4% previously).  Inventory/stock rundown typically exacerbates economic downturns, and is forecast to contribute negatively to overall GDP growth, by 1.4pp (versus -0.9pp previously).  Putting the components together results in 3.8% contraction in real GDP for the year, down from our earlier forecast of -1.2%.

We continue to model five quarters of sequential contraction (quarter on quarter), lasting from 2Q08 to 2Q09, although the plunge is now seen to be more severe in 1H09 than we previously anticipated.  Such contractions take the economy to a lower level before rebounding, therefore keeping year-on-year growth in negative territory for longer.  We now expect negative year-on-year real GDP growth throughout 2009, with contraction in excess of 5% in 1H09.  Meanwhile, we continue to expect a tepid recovery in 2010 (2.5% real GDP growth versus 2.7% previously), in line with the view of our colleagues in the global team, led by the rebound in trade growth to the low- to mid-single-digit range.

With respect to the labor market, more upcoming company closures and layoffs will likely accelerate the ascent of the jobless rate in the coming months.  We originally expected the unemployment rate to reach 6% by end-2009, from 4.1% at the end of 2008, but now think that it could surpass that level even earlier.  While the financial sector appeared to be the worst hit by the credit turmoil so far, the pain is already extending to the real estate, construction, trade, retail and hospitality sectors.

With regard to inflation, we published a detailed report last month, laying out our thoughts on pricing dynamics in Hong Kong in 2009-10 (see Return of Deflation by Late 2009, December 5, 2008).  Weak consumer demand is set to bring about rapid disinflation this year, although we may not see deflation until late in the year because the headline inflation rate is biased upward by the unwinding of fiscal concessions in 2H09, and we forecast 2% average inflation in 2009, followed by 1.5% deflation in 2010.  As we now see more weakness in the economy, it is probable that deflation could arrive sooner.  Nevertheless, we shall await the government’s budget plans for F2009-10, and assess the impact of any new fiscal concessions before revising our inflation forecast trajectory.

Deep Cyclical Adjustment, but Less Structural Pain Than Late 1998-2003

The onset and deepening of the current global macro downturn has surprised many in terms of both its pace and magnitude.  In just four months, we downgraded our 2009 growth forecast for Hong Kong several times, from 4% to -3.8%.  With the global macro outlook remaining murky at this point, and given the lack of visibility with regard to developments in the industrial world, we cannot rule out further revisions towards the record 6% contraction experienced in 1998.  Nevertheless, while the current recession seems to be approaching the severity of that in 1998 statistically, we remain convinced of fundamental differences between the two episodes.  Specifically, we characterize the current recession as a deep cyclical adjustment for the Hong Kong economy, which contrasts strikingly to the multi-year structural adjustment over 1998-2003.

Because of the brief internet boom in 1999-2000 that brought about a strong rebound in the economy, it is widely interpreted that Hong Kong went through a sharp recession in 1998 in the aftermath of the Asian Financial Crisis, and then another lengthy period of hardship in 2001-03 after the burst of the internet bubble, followed by the SARS crisis.  However, we see 1997-2003 as a prolonged episode of economic restructuring, through which Hong Kong revamped itself into a service hub for the Mainland economy, which is proving to be a much more sustainable economic model.  Manufacturing relocation to the Mainland was more or less completed during this time (manufacturing/GDP has declined to 3% currently, from 6% in 1997 and 23% in 1984), while construction expenditure downsized from 16% of GDP to 7% currently following the collapse of the property bubble.  Aggregate economic output growth stalled before the massive output gap was filled by the takeoff of service exports upon the boom of inbound tourism from the Mainland, and fundraising activities in the Hong Kong financial markets by Chinese enterprises.

In other words, the Asian Financial Crisis triggered prolonged rebalancing of the Hong Kong economy over 1998-2003, and the resolution of a host of structural issues associated with the shock from economic integration with the Mainland.  In 1998, Hong Kong was an ‘overpriced’ uncompetitive economy that saw China’s rapid development and cross-border economic integration as a challenging threat.  By 2003, Hong Kong had greatly enhanced its growth model and competitiveness, and was able to capitalize on the immense opportunities from economic integration with the Mainland.  Six years of deflation undoubtedly also contributed to the pain of the adjustment, but at the same time helped to build a much more robust fundamental position to weather the recession this time round.

To conclude, amid severe headwinds from the rest of the world, we now see a deeper recession for the Hong Kong economy this year, with a real contraction nearing 4%.  Negative real GDP growth is expected to sustain for five quarters from 4Q08, after four years of above-trend growth.  We cannot stress enough that as a small and open economy with large capital markets and a fixed exchange rate, Hong Kong is vulnerable to rather volatile economic cycles, manifesting and even magnifying the fluctuations in external conditions.  Nevertheless, while the economic contraction could be approaching the severity of that experienced in 1998 statistically, we see this recession as a deep cyclical one rather than another multi-year painful deflationary restructuring episode.

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Brazil
Growth Collapses
January 21, 2009

By Marcelo Carvalho | Sao Paolo

Recent data show that Brazil’s economy has come to a sudden stop. In fact, several activity indicators during 4Q08 display the worst decline on record. We reaffirm our below-consensus forecast for real GDP growth of 0% in 2009. This has been much more pessimistic than the consensus view. But in 3-6 months from now, we suspect that some will start to wonder whether our forecast sounds too optimistic. In turn, recent extraordinary growth data pave the way for the COPOM to embark on a monetary easing cycle this week on January 21. We are calling for a 50bp rate cut, but cannot rule out a more aggressive cut (75 or even 100bp) in light of a sharp growth downturn.

Growth Collapsed in 4Q08 

The global growth environment keeps worsening. In light of negative incoming data, our global economics team has revised further down its growth projections in recent weeks, pulling our global real GDP growth forecast for 2009 closer to zero. The global growth outlook envisages further weakening in 1H09, followed by modest recovery into 2010. The downside risks consist of a deeper downturn for longer – indeed, a recent IMF study concludes that recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions . In all, Brazil faces a severe global recession and the worst international crisis in decades.

In Brazil, recent data suggest that growth collapsed in 4Q08. Indeed, many December indicators now display the worst quarterly decline on record. The cumulative downturn from October through December is in fact the worst ever for car production, heavy vehicles traffic, business confidence and energy consumption (excluding the 2001 energy crisis). The drop in paperboard sales is close to an all-time record decline.

Retail sales are turning down too, although not yet as dramatically as other indicators. Retail sales fell sequentially in October, and again in November. The annual comparison slowed to 5.1% in November, from an average expansion of 10.4% in the first three quarters of the year, and marking the slowest pace in 28 months. The composition among components is shifting. Amid a previous credit boom, credit-sensitive items such as furniture and household appliances had been outperforming for a long time until 3Q08 – but now are underperforming. Likewise, the broader retail survey (including sales of automobiles and construction material) is declining much faster than the narrow headline survey, outright down 4.1%Y in November. In all, the slowdown in headline retail sales is not as dramatic as the plunge seen in other activity indicators. So far...

The outlook for sales is not bright, as consumer confidence should sink. While business confidence has already plunged at the fastest pace on record, consumer confidence has declined much more modestly so far. The apparent resilience in consumer confidence probably has to do with (lagging) labor markets, which have been robust for now. Going ahead, as firms cut back their output plans and cut their workforce, labor markets should suffer. Brazil’s unemployment rate averaged about 8% in 2008, an all-time low. But it can easily jump to 10% in 2009. Eventually, we believe that labor market deterioration will join forces with tight credit conditions to erode consumer confidence. In turn, retail sales will likely weaken further. 

The sequential contraction in industrial production intensified during 4Q08. Industrial production fell 2.8%M in October, and then plunged an additional 5.2%M in November. Based on other leading indicators already available, our models foresee an even larger sequential fall in December. To illustrate, the plunge in automobile production in December (down a massive 54%Y) is nothing short of spectacular. Our preliminary December IP forecast sees a sequential decline of 9%M, pulling the annual comparison down to -11%. If our forecast materializes, the cumulative sequential plunge in industrial production during the three months through December can easily prove to be the worst on record.

2009: Is Our Zero Growth Forecast Bearish Enough?

IP data heralds a very weak 4Q08 real GDP growth release, to come out March 3.  Industrial production is now falling far below its longer-term trend and real GDP growth looks likely to do the same, if history is any guide. Our forecast has penciled in a sequential real GDP growth figure of -1.0% (seasonally adjusted, not annualized) in 4Q08. Such a decline would contrast sharply with an average sequential expansion of 1.7% during the first three quarters of 2008. And recent data increase downside risks to 4Q GDP growth, which could easily show a sequential decline of 2% or even more.

A technical recession has already started. Given the sharply declining monthly growth profile during 4Q08, another negative sequential reading seems inevitable for real GDP in 1Q09 on average, even if there was some recovery in monthly indicators during 1Q. Conditions are set therefore for at least two consecutive quarters of negative real GDP growth – which is the conventional definition of recession.

The downturn is more than just a short-lived inventory correction. Many firms seem to be cutting back production in an effort to reduce excessive inventories – as usually happens at the start of a business cycle downturn. An inventory correction may thus have exaggerated the output decline in 4Q08. But this does not mean that a sharp output rebound is imminent, for at least two reasons. First, it is far from clear that the inventory correction is over. To the contrary, judging by a recent business survey, the share of firms reporting excessive inventories has actually jumped high, to about 20% in December. This contrasts with single-digit readings in the last few years. Second, demand conditions are set to remain depressed, even after firms manage to successfully bring down unwanted inventories. In all, the pace of contraction might ease in the coming months, but output should remain down.

Our forecast assumes that Brazil’s economy will remain weak in 1H09, with sequential recovery in 2H, consistent with the global view from our global economics team. For Brazil, we foresee a much deeper downturn than most analysts seem ready for. Brazil’s real GDP year-on-year comparison should slow from 6.3% in 3Q08 to less than half that pace already in 4Q. By mid-2009, the annual growth comparison is likely to turn negative.

Our GDP forecast has consistently been below consensus. However, we suspect that our growth forecast might actually start to sound optimistic to some observers within the next 3-6 months. One common pushback to our below-consensus view on the 2009 growth outlook is that strong momentum from 2008 would provide a floor for average growth in 2009. But the 4Q08 growth collapse can easily erase any statistical positive carryover from 2008 to 2009. In fact, simple extrapolation of most recent trends would actually imply negative average real GDP growth in 2009. We do expect a sequential growth rebound in 2H. But the starting point for that recovery will likely prove much weaker than most analysts seem to have assumed.

In turn, the collapse in recent growth indicators, coupled with benign inflation readings, pave the way for monetary easing. The global monetary easing cycle has already arrived in Latin America, and Brazil is likely to join the trend by cutting rates on January 21 (see “Latin America: Easing Cycle Begins”, EM Economist, January 16, 2009). We are calling for a 50bp rate cut, but cannot rule out a more aggressive move (a rate cut of 75 or even 100bp) in light of massive weakness in recent data. Still, we feel skeptical that monetary easing will be able to shield the economy from powerful global headwinds.

Bottom Line

Brazil’s growth collapsed in 4Q08, with several activity indicators displaying the worst decline on record. We reaffirm our below-consensus forecast for zero real GDP growth in 2009. This remains much more pessimistic than the consensus view. But in a few months from now, our forecast might sound too optimistic to some. In turn, economic weakness should pave the way for the COPOM to start cutting rates this week.

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